A firm\'s current balance sheet is as follows: Assets $100 Debt $10 Equity $90 (

Question

A firm's current balance sheet is as follows:
Assets  $100        Debt        $10
                                Equity      $90
(a) What is the firm's weighted-average cost of capital at variouscombinations of debt and equity, given the followinginformation?

Debt/Assets           After-Tax Cost ofdebt         Cost ofEquity            Cost of Capital
   0%                                       8%                                  12%                                ?
   10           8          12          ?
    20                                        8                                     12                                   ?
   30                                         8                                     13                                   ?
   40                                         9                                     14                                   ?
   50                                        10                                    15                                   ?
   60                                        12                                    16                                   ?
(b) Construct a pro forma balance sheet that indicates the firm'soptimal capital structure. Compare this balance sheet withthe firm's current balance.

Assets              $100                                Debt              $?
                                                                    Equity            $?

(c) As a firm initially substitutes debt for equity financing, whathappens to the cost of capital, and why?

(d) If a firm uses too much debt financing, why does the cost ofcapital rise?

Explanation / Answer

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